SEC probing into USA listed China small cap stocks is splashed all over the media right now. China Digital Media (CDGT) is front row center for a SEC pump-and-dump scandal, and the on-going argument of accounting differences between SEC and the SAIC reports continues to be publicly debated.

20 percent of the China-based, USA listed, stocks (45 out of 227) that show up on FINIZ screener have over 10% of their float short. The top 6 stocks have between 30 – 60% short which are: China Shen Zhou Mining (NYSEMKT:SHZ), Yingli Green Energy (NYSE:YGE), RINO International (OTC:RINO), China Dangdang (NYSE:DANG), Telestone Technologies (NASDAQ:TSTC), and China-Biotics (CHB).

For many, the volatility risk is simply too high. Some are short-selling into fear, which can make a quick buck, but knowing when to cover is vital as when prices jump, they can jump fast. We will look at a couple of reasons why it might be good to buy some China small caps for the sliver of high risk in your portfolio.

The argument between accounting differences is not necessarily one of fraud. The SAIC (China’s State Administration of Industry and Commerce) is primarily for business registration and licenses. While some financial numbers are included with the paper work to the SAIC, these are not audited. While some complain that these numbers should match anyways, consider this: when trying to get a new credit card, financial information is usually required such as annual earnings. However, we usually take a more lax view of this report than we do on our taxes.

Furthermore, there are some accounting practices in China for the SAIC that are different than those of the SEC. This can relate to where revenue was earned (inside or outside of China), money and assets in foreign countries, and so forth.

Finally, there may be incentive for China based companies to under-report earnings or keep the financial reports a bit murky for the SAIC. There could be reduced tax benefits or less transparency for nosy competition or clients trying to negotiate a better deal.

Valuation Already Factored In?

The fear is not totally unfounded, but perhaps it is already factored in to share prices at this point. Does this mean that all Chinese small caps are a good buy? No, but perhaps we can lessen the risk by not only screening for good fundamentals, but also a good auditor. There are the Big 4 (Pricewaterhouse Coopers, KPMG, Ernst & Young, and DTT), and the top 10. All our China picks will include a reputable auditor to reduce the risk of shady accounting.